Regulatory Bank Capital Ratios and Market Measures of Risk

This paper analyzes how bank capital ratios affect the safety of banks. The main finding is that higher capital ratios following Basel III significantly reduced risk for large European banks. Large banks with a higher capital ratio have a higher asset quality, a lower stock return volatility, and a lower contribution to systemic risk. These results indicate that Basel III has been effective in increasing the safety of the financial sector. The novelty of this paper is that it proposes a method to estimate a Tier 1 capital ratio that is not influenced by changes in the definition of capital, thus allowing for a better comparison of pre- and post-Basel III Tier 1 ratios. Using this new measure, this paper finds that banks have increased their Tier 1 ratio by 6 to 9 percentage points on average, compared to pre-crisis levels.